How Much Life Insurance Do You Really Need?

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There’s a problem at the intersection of human nature and life insurance: When you’re young and healthy and able to get cheap insurance easily, you can’t imagine needing it—or at least not enough to go to the trouble and expense. But if your health declines and you suddenly find insurance compelling, you may not be able to get it, or at least not at a price you can afford.

That’s why it’s essential to think about how much life insurance you need when you are healthy—particularly if you’re about to have, or already have, kids or others who rely on you.

In theory, lots of Americans understand this. About 50 million households recognize they need more life insurance, according to a 2018 Insurance Barometer study by non-profit insurance education group Life Happens and the Life Insurance and Market Research Association (LIMRA). And among those with life insurance, about one in five say they do not have enough. In fact, the average size of the life insurance coverage gap is about $200,000, LIMRA found.

But knowing this, in theory, doesn’t make the actual process of figuring out what and how much to buy easier. So here’s help.

Life is priceless, says Dennis Rupp, a director at TIAA Life. And life insurance can be more affordable than you think.

Types of Life Insurance

While there are many different types of life insurance policies, they usually fall into two buckets: term or permanent insurance.

Term life insurance is usually cheaper, as it only provides protection for a certain period. Terms can range from one year to 30 years, although 20 years is the most common term, according to Life Happens. This option can be useful if you have identified a specific need and time frame in which it will be necessary to have life insurance. For example, you may only want life insurance until your children graduate from college. So, if, for example, your children are now toddlers, a 20-year term might fit your needs perfectly.

The only thing to be cautious about with term life insurance is that if you want to renew or buy a new policy after your current term ends, it will likely be more expensive. This is because insurers take age and health into account when determining life insurance premiums. If you buy a 20-year level-premium policy when you’re 35, don’t expect to be able to renew it for the same annual premium when you’re 55.

Permanent insurance, by contrast, gives you protection for life, as long as you make regular payments. It’s also more expensive and has an investment component. There are many kinds of permanent life insurance, but the most common is whole life insurance.

Whole life insurance offers a savings account in addition to a death benefit. The savings grow “based on dividends the company pays to you,” according to the Insurance Information Institute. There is also universal life insurance, which is a bit more flexible. It offers adjustable premiums, as long as you meet a certain yearly minimum.

Variable life insurance can be good for those looking to take on a bit more risk. It offers death benefits and a savings account that can be invested in stocks, bonds and mutual funds. (You can read the case for life insurance as an investment here.)

For most people, though, term life insurance is the better—and unquestionably simpler—choice. Most people don’t need lifetime coverage, as your financial obligations (such as supporting children and paying off a mortgage) decrease as you get older.

Financial advisor Mark Zoril, founder of Plan Vision, says he’s never been able to justify permanent life insurance. “[With permanent life insurance], a lot of your premium goes toward the investment and to pay for the cost of the policy,” Zoril says. “You can definitely get more insurance if you buy term life than if you buy permanent life.”
Term insurance is certainly more affordable for the average American. Permanent only makes sense for the insurance component if you have a lifelong need for insurance, such as a child with special needs. And while the investment component is intriguing, a 401(k) or IRA usually offers lower fees and better returns. More often than not, for middle class families, permanent life insurance is not worth the money.

When Should You Consider Life Insurance?

Definitively, the best time to buy is, first, when you don’t need insurance and, second, when you are young, says Marvin Feldman, CEO of Life Happens. This is because the premiums are lower at this point, he says. “There is no age where it’s wrong to have life insurance,’’adds Jim Scanlon, a senior research director at LIMRA. In most cases, however, it does not make financial sense to buy life insurance for your children. (And no, life insurance is not the best way to save for your child’s college education.)

Usually, major life events trigger people to shop for life insurance. Scanlon lists these as getting married, buying a home, having a child, starting a new job or the death of a friend or family member.

According to the 2018 Barometer study, the top three reasons Americans gave for owning life insurance in 2018 was to cover burial and final expenses, to help replace lost wages or the income of a wage earner and to transfer wealth or leave an inheritance. However, most people put off buying life insurance because they believe it costs too much. Feldman says they typically overestimate the cost by about five to 10 times.

For example, in the Barometer study, more than 2,000 adult consumers were asked how much a $250,000 term life policy would cost for a healthy 30-year-old. The average cost is about $160 per year. Almost half of the Millennials surveyed instead estimated the cost at $1,000 or more per year—more than six times the actual cost.

How Much Insurance: Rules of Thumb

The 10-times rule

The classic life insurance “rule of thumb” is that a consumer should have 10 times their income in insurance benefits. Other variations of this rule say you should have five or seven times your income. But Feldman, of Life Happens, says that one-size-fits-all rule doesn’t is outdated.

“When I’m talking to people, I’m saying that it might be as low as five times [your income],” he says. “It might be 20 times, and it might be more than that, depending on what your debt is, if you want to give anything to charities, etc.”

Advisor Zoril says he typically helps clients calculate their debt and income to find out how much life insurance they need. They typically arrive at a number that is in the area of seven to 15 times their salary, he says.

The DIME rule

The DIME Rule is an acronym that stands for debt, income, mortgage and education expenses. It calls for adding these together to find out how much life insurance coverage you should get:

Debt and final expenses: Take a tally of your debts, and add funeral expenses and other final expense in to that.

Income: Calculate how long your dependents will have to live off your salary and then multiply your income by that number.

Mortgage: Decide how much you need to pay off your mortgage.

Education: Finally, add the amount you think you’ll need to leave to pay for education for your children.

However, this formula doesn’t account for existing life insurance or needs for a stay-at-home parent, Rupp, of TIAA Life, says. Instead, Rupp recommends following the “financial obligations minus liquid assets rule.” Under this, you’ll need to calculate your obligations, your annual income multiplied by the number of years you want to replace your income, your mortgage balance and other debts. From that, you’ll subtract liquid assets, such as savings or existing funds, he says.

The LIMRA model

LIMRA has also created its own life insurance needs model. Under this model, Scanlon suggests that if you have a spouse or child you should have enough insurance to replace 75% of the insured’s income for seven years. This equates to about 5.25 years of their annual income. Of course, he says, that is a minimum benchmark that can fluctuate based on a person’s individual situation.

Other Factors to Consider

Experts agree, there is no “magic number” you should aim for or right answer when considering how much life insurance you will need. Instead, you’ll need to calculate this for yourself based on your personal situation.

Scanlon and LIMRA maintain that a person should think about four buckets when considering how much life insurance they need:

1) Burial or final expenses

2) Income replacement

3) Debt repayment

4) Wealth transfer

“Those are the solid ones,” he says. “If you were to get into something like the wealth transfer or income replacement discussion, then a lot of details to consider might come forward, like the age of your dependents. You might think about what income stream you had planned for yourself.”

Be sure to think about your future income. Do you expect raises and promotions? If so, account for that in your final number.

The number one thing to keep in mind is that it is more important to have some coverage than none at all, says Emily Johnson, head of insurance products at Fabric. The startup offers accidental death insurance policies and 20-year term life insurance online starting at $10 a month (for a healthy 21-year-old).

She also recommends asking yourself these questions before deciding how much coverage you need:

How long are your children going to be dependent on you?

Will a surviving spouse need to make car payments or mortgage payments?

Do you want to make a charitable donation?

Will a surviving spouse need to hire someone for childcare?

Do you have any loan co-signers who may be responsible for your debt should you die?

Currently, over a third of all households would feel adverse financial impacts within one month if a primary wage earner died, according to the Barometer study.

Another important thing to remember: Proceeds paid under a life insurance contract don’t need to be reported as taxable income, according to the IRS. (This is true for both life insurance you get through your employer and life insurance you buy on your own.)

But what if you are super wealthy, and have more than you think you need saved up? Many in this scenario wonder if it makes sense to invest in life insurance. “The question for these individuals is do they want to pay off outstanding financial obligations with their money or the insurance companies’ money, which can be purchased for pennies on the dollar,” Feldman says.

Compare the premium on the policy to the face amount of the death benefit provided, he says. If the premium is $500 and the death benefit is $500,000, the cost is only $.001 per dollar per year for the protection provided.

“For high net worth families who may be subject to estate and inheritance taxes, life insurance provides a very cost-efficient tool to pay the taxes, so the family does not need to liquidate resources to pay these taxes,” he says. “Life insurance can provide a significant savings over asset liquidation. “

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